Worried About Rising Interest Rates? Consider Building A Ladder

Jan 28, 2015

Article By: Scott Burns

Q. I am 70 years old and retired. I have seen many recommendations to shorten up on bond duration as a way to protect against rising interest rates. But with federally insured three-, four- and five-year certificate of deposit yields now at 1.5, 1.9 and 2.2 percent wouldn't a simple CD ladder be a better choice?

It seems that by the time the short and intermediate term bond funds recover from much of an interest rate increase, the CD's would probably have reached or be near maturity and be ready for roll-over at higher rates. ---L.M., Frisco, Texas

A. Laddering is a good solution for those willing to put in the time and effort to do it. Done long term, it is a great way to get the yield of a longer maturity, while having an average maturity that is significantly shorter. For example, if you have a three-year ladder with maturities from one to three years, the average maturity will start at two years, and then decline to one year as the first CD matures. Then the average maturity will be back to two years again when the maturing CD is replaced. That cycle will continue as you replace each maturing CD with a new three-year CD.

The problem today is that building a ladder is a lot of work. Let me give you an example. According to the bankrate.com website, the national average yields on one-, two- and three-year bank certificates of deposits were 0.26 percent, 0.40 percent and 0.52 percent, respectively. So if you purchased equal amounts of each (and jumbo rates are slightly higher) you’d have an average yield of 0.39 percent. That's about the same as the yield on a two-year CD, but with the benefit that one-third of your investment comes back to be reinvested within a year. Better still, as each certificate matures it is replaced with a new three-year certificate.

In a few years you’re getting the yield on three-year certificates but your money, on average, is committed for a much shorter time.

The reward for this is greater if you are willing to do some shopping. The highest yield on identical maturities that I could find on a recent visit to the bankrate.com website were 1.15 percent, 1.35 percent and 1.54 percent, respectively. That’s an average of 1.35 percent, which is quite a leap over the national averages rate of 0.39 percent.

Another area of opportunity that is secure, but not as secure as a FDIC insured certificate of deposit, is a CD-like tax-deferred annuity (TDA). Danny Fisher, otherwise known as “Mr. Annuity” in Dallas, regularly posts a top 10 list on his website with maturities from three to 10 years. At the same time that the highest yield in the country for a three-year CD was 1.54 percent, he listed a three-year TDA at 2.40 percent. Similarly, five-year CD-like tax deferred annuity provided a yields ranging from 2.9 percent to 3.2 percent. His top 10 lists can be found at mrannuity.com. (Note: The TDAs generally have minimums of $3,000 to $10,000.)

Another advantage of the TDAs is that the yield is tax-deferred, so you may be able to benefit from better timing of when you take your interest income. Shopping and flexibility pay off. But they also take time.

Q. I am a Coach Potato investor with Vanguard. I would like to know your opinion on the asset allocation I saw outlined in a recent news story about a “permanent portfolio allocation.” The portfolio is equally divided into four parts:

Cash

Long Term Bonds

Stocks

Gold

Sounds like something to consider.

A. The problem with the permanent portfolio, which can be traced to the late newsletter writer Harry Browne, is that it is a portfolio of extremes. Its commitment to gold can be dead money for years, even decades, and then suddenly be the main engine of the portfolio.

We can get some idea of how extreme by taking a look at how it has ranked against other funds that Morningstar calls “conservative allocation” funds. Over the last year, three years and five years it ranked in the bottom ten percent of its competition. Over the last 10 and 15 years it ranked in the top 10 percent. Most people don’t want to live with such extremes.

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